Thursday, July 19, 2007

Your home's value and your net worth

Mighty Bargain Hunter recently published this post on why he does not consider it appropriate to include the value of his home in his net worth calculation. As the comment I submitted appears to have been lost in the internet or caught in a spam filter (the story of my life), I set out my comments here. [Edit: it looks like the delay in publishing was due to a spam filter. My comments now appear on Mighty Bargain Hunter's blog.]

There have been many articles written about whether a person's home is an asset or a liability and whether it is relevant to retirement planning. My take on these questions is set out in these three posts: Part 1 , Part 2 and Part 3 .

Mighty Bargain Hunter makes the very valid point that an over inflated sense of financial net worth can be dangerous - especially to people who lack even a modest degree of financial self discipline and, on occasion, even to those who are reasonably savvy. Some of the horror stories of people who borrowed against their home equity to finance consumption spending illustrate the point very well. While I am of the view that home equity is part of net worth, if excluding it from your personal balance sheet motivates you to save more or to spend less, then excluding it is the right thing to do.

However, I must respectfully but strongly disagree with some of other reasons given for not including home equity in a net worth statement:

1."I didn’t earn a dime of that increase. "

This is not true. Mighty Bargain Hunter earned every penny of the increase when he risked his deposit (if any), his credit rating and his future cash flow in taking out the mortgage loan and making the purchase.

2. "The increase in my net worth is a gift from easy money policy and wild real estate speculation."

So what? I really struggle to see why this is relevant to the question of whether or not to include home equity in a net worth calculation. While easy money policies and speculation did contribute to increases in real estate values, studies have shown other factors to be more significant: land supply, planning restrictions and demographic shifts among them. More to the point, the same easy money policies and speculation have also contributed to increases in equity prices. If home equity is excluded on this basis then logically equity price gains should also be excluded. Another problem is that if this logic was applied consistently then any increase in value of an investment property should also be excluded? My take is that the cause of an asset increasing or decreasing is irrelevant to issue of whether or not to include that asset in a net worth calculation.

Another way of looking at the issue is to ask whether you would take negative equity into account if the value of your home declined due to tighter credit conditions (rising interest rates) and panic selling? Failing to do so would consistent with the view that increases in the value of home equity should not be included in a net worth calculation. However, that approach would create the same problem that Mighty Bargain Hunter is addressing - it would over inflate the net worth picture.

My own take is that I include both the asset (our home) and the liability (our mortgage) in my net worth calculation. I do this for two reasons:

1. I like to see the complete picture;

2. home equity is important to my retirement plan and it is important to keep track of it as part of the planning process.

If I felt that excluding the value of my home equity from the calculation would improve my financial management, then I would consider taking a different approach.


Anonymous said...

I have to agree with you. My rule of thumb is to include all non-depreciating assets on my balance sheet. Of course, all assets go up and down in value, but real estate, over time, appreciates. So I include my home on my balance sheet, but not, for example, my cars.

Anonymous said...

I'm a bit late to the party but thanks for your thoughts on my post!

Ultimately my way of taking my home's value into account is psychological I suppose, more to avoid the temptation of seeing my equity as real money that I can dip into than calculating how much I'm worth. (Which makes you wonder why I called it "net worth calculations" -- hence your point.)

Those that did dip in are going to be in trouble. If someone read my post and thought twice about taking out a HELOC for consumer spending then it served its purpose.

Again, thank you for the thoughtful post.